Should You Prepay Your Mortgage?

Welcome to Throwback Thursday! Many in the GRS community have been reading the site since J.D. Roth began posting in 2006, but many of you are new to the community. We’re going to start re-posting some of the most popular — and useful articles — from the past. The financial advice and ideas are still valid, and well worth bringing back to light. Originally published on June 17, 2006, this article offers various points of view on a common decision homeowners face.

You can save tens of thousands of dollars by prepaying your mortgage. But is it a smart move? A CNN Money reader asks expert Walter Updegrave:

The psychological freedom of not having a mortgage is very appealing to us, but the argument for trying to invest the extra cash at a higher rate is compelling too. What’s your take on paying off the mortgage early?

Surprisingly, this is one financial point on which the experts do not agree. Updegrave says:

My advice is to first make sure you’re maxing out your retirement savings plans and make sure you’re on track toward a comfortable retirement. Once you’ve got that front covered, you can start paying off that mortgage more quickly to reap those psychological benefits you find so appealing.

In The Laws of Money, Suze Orman says just the opposite. She doesn’t care about tax write-offs. She doesn’t care about potential gains in the stock market. Paying off your mortgage offers a guaranteed return on investment: “You cannot live in a tax return. You cannot live in a stock certificate. You live in your home.” Orman says to invest in the known before the unknown.

The authors of All Your Worth suggest a combined approach: 10% of your income to retirement, 5% to paying down your mortgage, and 5% to save for future dreams. “Paying off your home also does something many financial planners neglect to mention: It gives you freedom. Once that mortgage is gone, just imagine all the freedom in your wallet.”

In Wealth Without Risk, Charles Givens offers a novel approach to prepaying a mortgage. “On the first of the month when you write your regular mortgage check, [include extra] for the ‘principal only’ portion of the next month’s payment.” Using my own $1,625.65 mortgage payment as an example, $239.55 is designated for the principal. If I were to make a payment of $1,865.20, I would be making approximately an extra monthly payment! If I do this every month, I’m cutting the term of my loan in half.

If you do decide to accelerate your mortgage payments, try to do it on your own, whether you pay one full extra payment during the year, or pay 8% extra every month. Banks often charge a fee to add this as a formal service, but you can do it for free yourself!

it probably depends on what your interest rate is. if you’re paying 10%, then by all means knock off huge amounts of interest by prepaying (if you can’t refinance). if it’s 3%, then pre-paying probably isn’t worth it. invest the money and get a greater than 3% return, and you can use the higher amount to pay the mortgage down later on.

consider this, too: if you lose your ability to pay the mortgage down the road, all of the payments that you’ve already made are lost. making an early payment is throwing good money after bad, in that situation. more of your money than necessary has been subjected to the risk of being lost to foreclosure, without getting you any extra security beyond what your monthly payment gets you. all else being equal, it makes more financial sense to hold off until you can pay off the entire amount of the mortgage.

i think that’s the right approach, nicole and maggie. the conventional advice – buy the most expensive home you can afford as an investment, because housing prices always go up – strikes me as a little insane. buying a home makes sense for a stable, affordable living situation, not as an investment (unless you’re really rich). it’s also my understanding that home prices do not have a particularly good return (i haven’t had a chance to read robert schiller’s “irrational exuberance” yet, but i understand that the second edition has a good discussion of the housing market and why it’s not at all special).

my plan is to buy the *cheapest* house that i can fit the family in and put the money saved in an investment account. that way i’ll have the cash in the event i lose the ability to make mortgage payments.

(i’m a lawyer who represents homeowners in trouble with their mortgages – that’s why i keep bringing up default and foreclosure – it’s always on my mind.)

I think one of the challenges for the site is the saturation of the personal finance topic. When JD started his site he was ahead of the curve (one of the various reasons it worked out so well for him) and had the opportunity to hit these topics the first time. I like the idea of bringing back the throwback stories because it refreshes the conversations and brings them up to speed with the current events that may have changed the situation.

This question is far better solved by math than by the aphorisms offered by any of the above listed gurus and books. You simply compare the interest rate on your mortgage to the expected return of whatever else you could be investing in. Whichever rate is higher, wins.

As for homes being investments, the recent housing crash should have taught us something about that. In some hot real estate markets (NYC, San Fan, etc) homes are investments as they’ll increase in value faster than inflation. In other areas, houses generally track inflation – making them stores of value rather than investments. So most people should buy the house that fits their needs rather than the biggest thing that they can afford.

People without large families or space intensive hobbies may actually be better off not buying a home at all and renting instead. Knowing your local real estate market, being aware of your housing needs, and running some quick numbers will give you an idea of whether this is true for you or not.

Finally, I realize that there is some subset of people from whom debt of any kind makes them unduly neurotic. Maybe for this group of people prepaying a mortgage is a good idea simply for the peace of mind that it offers.

I actually find a lot of standard advice about prepaying mortgages/paying off mortgages very frustrating. Not only do experts not agree, but the advice is often oversimplified.

All things being equal, of course you do better investing at a higher interest rate. Simple math, as you say. However, a lot depends on where you are in your financial life, and what your goals are.

On the one hand, mortgage is a guaranteed rate of return, and most investments are not. Yes, you can LIVE in your house, so that’s a plus. It’s also a minus, because it locks capital up in a non-liquid form. You can potentially get a home equity loan/line of credit, but that comes with interest. If your house is paid off but you have drained all your cash savings to pay it off early, you still have to eat and pay medical bills. Then you might need to sell the house to get at the equity, but you will STILL need somewhere to live.

Then there is the stage of life. Liquid cash gives flexibility that locking the cash up in home equity doesn’t. One thing that bugs me about retirement advice is the assumption that is usually made that the person will 1) stay in their house forever, or 2) downsize as soon as their kids are gone (to a cheaper house). But that is certainly not our situation (no kids, small cheap houses, town we can’t stand). When we finally are able to relocate, anywhere we go will likely be substantially more expensive. There’s no point in sinking a bunch of cash into our two starter homes, if we potentially need a big chunk of liquid cash to relocate.

As with so much of personal finance, simple rules of thumb are helpful, but they need tweaking based on the individual situation.

You bring up a good point about where you are in life. I’m in my early 40′s and would like to enter retirement without a mortgage, so I plan to payoff my mortgage within 20 years or less. Mathematically it would probably be better to put the money in a retirement fund, but I want the freedom and flexibility with a mortgage free home when I retire. I could downsize from a townhouse to a flat (less likelihood of falling and broken hips), and the amount I’m paying on a mortgage could be reallocated to health care :/

If I were in my 20s or 30s I might have a different idea of what to do.

Another mathematical way that I look at it is not comparing interest rates, but comparing the cost per month. For example, I’m paying 4% interest rates on about an $8000 student loan, and the payment is $140 a month. I could pay it off today, but it would take me 4-5 years to save that money back up with the extra $140 a month it would get me. While this is short term thinking, I’m trying to meet a more important financial goal by next year, so it makes sense for me right now to keep the big payoff in my savings, and pay the monthly payment.

Likewise I’m not in a hurry to have all my money completely tied up in my house, when I don’t plan to stay in it for the rest of my life anyway. Maybe it’s because I have kids now, but having a nice cushion in the bank account makes me feel way more secure than having a loan paid off. If it comes down to it, I can default on a loan, and having loans paid off would be no consolation if an emergency occurred and I couldn’t pay for healthcare, for example.

As I near retirement, I have been prepaying my mortgage for a few years. I feel a little conflicted because I am sitting on a huge asset which I prefer to leverage. My solution is to maintain a line of credit for some of the equity.

For most people, paying off a mortgage makes a lot of sense, but paying down a mortgage does not.

Instead, set aside the money you would use to pay down the mortgage, in low-risk investments. This will probably provide you with a slightly better return, but that’s not really the point. Instead, it provides you with security against job loss or some other financial crisis.

Regardless of the balance on your mortgage, you’re still responsible for the same monthly payment. By “paying down” that balance in an account you control, you retain the option to redirect those savings to future monthly payments, if necessary.

I used to think that, but then I found out that if you’ve prepaid, you can re-amortize (aka recast) your loan pretty cheaply (usually a ~250 one-time fee). That means that you can decrease your monthly payment in case of emergency. So not so dangerous to prepay as if you couldn’t do that.

But the last one was WAY out-dated. At these interest rates, if you doubled up your principal payment every month, you’d shave 20 years off of a 30-year loan. OF course, this points out the benefit to today’s young people. The days of “mortgage versus invest” are kind of gone. Today’s young people can just easily do both, with lower interest rates and lower mortgage payments.

I also have come across a lot of ignorant comments in recent years about how mortgages work. Smaller interest rates just create an entirely different animal.

For Example, Our first mortgage was at 8.25%, and $130 of our $1500 payment was going to principal, at the beginning. Today we have a 3.75% mortgage and on the first payment, $300 goes to principal and $600 goes to interest. Anyway, I get a lot of ignorant comments about how we shouldn’t refinance so much and how obviously only $100/month is going to principal and yadda yadda. Interestingly, the only reason it is taking me an entire 30 years to pay off the new loan is because the payment is so much smaller and so less goes to principal on the back end. My 1-year-old 3.75% mortgage puts us about exactly where we would have been (total remaining balance and monthly principal payment) as if I had never refinanced my first mortgage (which would have been 12 years old now). This is true until about year 17, when the bigger principal payments start to pile on. (& of course, I refinanced so we could shave $600 per month off of our payments, while mostly being in the same boat otherwise).

I just ran the numbers on my recently refinanced 3.75% mortgage, and it would turn the 30 year term into a 17 year mortgage. So not quite half. At higher interest rates, its less effective (18 years and change at 6.5%).

It also would turn an $800 a month P&I payment into $1070 initially, and $1300 in year 17.

It worries me that so many people are retiring without having paid of their house yet. However you decide to do it….I think ownership of house and land is the important thing for security…..and Do Not take out a second mortgage on it. So many families in our area have ended up losing their house because of that. Suzie Orman gets dumped on about this but I agree with her totally re paying off a house and not taking a second mortgage on the house you live in. We started out with a 30 year mortgage…refinanced to a 20 year 5 years later and should be totally paid off in a few years with about 16 years of payments. An extra payment is the first thing that comes from our yearly tax return which is painless and we always throw in a few extra dollars into the principal every month.

i get paid bi-monthly (26 pay periods a yr), so on the months when i get 3 cheques, i made prepayment with the extra pay cheque. I didn’t even notice a dent in my lifestyle but it cut my mortgage down by years

We were in the unique situation that, in our early 60′s with me retired and husband wanting to retire in a few years, we sold our house and moved 1000 miles to be near family. We rented for a year, then bought our house 9 months ago. We could have paid cash for it. Instead, we put 50% down and took a 30 year fixed @ 4.25%. We went this route because our investments are returning an average of 6% and we didn’t want to tie up 20% of our savings in a house. Husband has since “gotten retired” (fired) and we have a mortgage running into our 90′s and wee’re good with that.

The real answer is “it depends”. The fact that these “experts” have a firm opinion is a clear indication you shouldn’t pay too much attention to any of their opinions.

The first consideration is what interest rate you are paying. If it is less than 4% per year, you will likely make more money from investments than you will save in interest by making early payments.

The second consideration is inflation. You are making future payments with today’s dollar. If a dollar is worth half as much at the end of your loan, then you are giving up twice as much value as you would by making that last payment on schedule.

The third consideration is liquidity. How many other assets do you have beyond your home? Because, while your home has value, that value can be hard to extract when you need it.

The fourth consideration is security. You can secure your home by paying off your mortgage. But doing it in pieces actually makes you less secure. If at some point in the future you can’t make your regularly scheduled payment, usually those earlier payments won’t save you from foreclosure. By contrast, saving the money you paid on your mortgage would allow you to make your regular payment. And, once you have saved enough, you can use it to pay off the mortgage. Of course, whether you come out ahead will depend on the earnings you get on the money you save.

The fifth consideration is how much of your mortgage is really deductible. A lot of people would not itemize at all if not for their mortgage. The tax advantages only apply to the value the mortgage gives you over the standard deduction. If you don’t have a lot of other deductions to begin with you aren’t really getting the full value of the mortgage deduction.

Paying off your mortgage early may make sense if you are nearing retirement and have a lot of other liquid assets. You have most of your assets in low return, low risk investments. You are paying a high interest rate. You have very few other tax deductions. You are already saving money in a variety of other investments.

In short, paying off your mortgage is a low risk, low return investment. The real question is where does that fit into your investment portfolio.

The idea that you somehow get “freedom” by paying off your mortgage, rather than saving the money so you CAN pay off your mortgage is the kind of pop-culture investment blather you ought to ignore. If you lose your job, you are going to be a lot more “free” if you have the money to make your mortgage payment than if you spent that money trying to pay it down faster.

You have the same approach that I do, it appears. Great point about the interest deduction. Even with two mortgages, we are only able to get over the standard deduction by doubling our property tax payments every other year. So we only get that advantage half the time.

Idea of having old popular articles is great. (I had missed it earlier
Having views of different Personal finance experts at one place is great. But isn’t there some calculator which can help me decide what to do?

It helped me decide what to do since I can’t get a loan modification or a refi and I owe less than 45,000. Instead of paying closing costs and fees and all/most of my payments going to interest,I am able to pay on the principal and cut my time down without the bank deciding how I do it.

We chose to prepay our 6.5% loan because it was a private loan from a family member. Instead of 20 years we paid it off in 7. Doing the math we saved $32,000 in interest. If we had invested the extra we paid each month and earned 8% annual return on it we would have had $49,000 in savings at the end of 7 years, so we theoretically lost $17,000 by paying early but we felt it was the right thing to do at the time.

I would never consider my home an investment. As Ross Williams says above, you have to live somewhere. I’m a firm beliver of living in a modest home with a mortgage payment that does not prevent you from saving for the future and enjoying the present.

My decision to not prepay my mortgage at this time is based on a mix of emotional and financial reasons. I’m going to be 30 next year, and while that’s not quite old-fart status yet, I’m planning for some expensive changes in the next few years that I simply don’t want to put off any longer. Those changes include a career change which involves going back to school and persuing individual skill-enriching activities that will help me get a job in a competative industry.

Also, I’d like to start my investment property portfolio no later than next year. I only make so much money, so for me to prepay my mortgage would mean to forego those other goals indefinitely. Yes, there is no guaranteed ROI with the real-estate venture, but neither is there a guaranteed ROI on prepaying your mortgage like so many PF writers and proponents of the practice suggest. As others have mentioned already, anything could happen before you can pay off the mortgage…and that money could be lost. The only guaranteed ROI you can get from paying off the mortgage early, is to write one, clean pay-off check. Other than that, you’re in the same risk boat as errbody else.

Add to it the fact that my interest rate is 5.375% (not too high), and my mortgage is $354/ month. While it would be nice for that cost to go away, it’s hardly the life-changing amount that it could be if it was maybe $700 or more, and to me, not worth the time, effort, and sacrifice I would have to make to make that happen.

Once I finish school, have a full-time job in my chosen career, and have at least 2 rentals under my belt, I will pay off the mortgage the second I have enough to pay it in full. For now though, 100% of my savings are spoken for, for the next few years. Luckily I’m still fairly early into my mortgage that I think I’d still get a decent ROI by the time I am ready to pay it off.

You didn’t mention if you’re saving for your retirement or not. If not, please, please do not put it off. Take it from an “old fart” who has been able to see firsthand what the true miracle of compounding can do given enough time.

You’re absolutely right. I should clarify….all NON-retirement and e-fund savings are being directed towards my short-term goals. I’m not currently saving as much towards retirement as I would like to in the future, but I started early and save up to the employer match, plus I have a ROTH (that I’m not currently contributing towards ATM), and hope to use the rental properties as income and as part of my retirement portfolio, so I’m not too too worried about maxing out retirement savings yet.

Glad to hear it. I’m a little bit of a fanatic on the subject because when I was younger I chose to prepay on my mortgage instead of putting the extra towards my retirement, then I chose to pay for college for my children. Now I’m putting a large percentage of my income towards retirement. I wish I had used a more balanced approach earlier.

When I have available cash flow, I allocate some percentage to investing and some to prepaying. Liquidity can be both a blessing and a curse. Personally, I find building equity to be much less interesting than investing, but I do it anyway… perhaps as a hubris-avoidance tactic. I’ve heard plenty of people ruined by bad investments, but I can’t say I’ve heard of anyone ruined by paying off their mortgage early.

You’re right Nick, up to a point. Every financial professional can tell you that one of their most-heard laments is:

“I wish I’d started saving for retirement sooner.”

Stuff the retirement fund first and then feel free to toss any extra cash at the mortgage. You won’t regret it and you’ll be able to pay your taxes and upkeep on your “paid for” home forever. Provided, of course, that you don’t make bad investments. But hey, you’re a student of GRS, so that’s not going to happen.

Agreed. I had surplus cash 6-7 years ago and instead of paying off approximately $250k in home morgage bought into an investment idea of a friend who talked me into financing 5 investment homes in a lower income Atlanta area. A $20-40k house to rent seemed like a low risk sure thing. Post crisis and some minor fraud later, the houses proved value-less. While the loss was tax deductable, the expected 10% vs 3% return actually became a loss of over $100k, even after taxes. I would much prefer right now to own my home free and clear. While I could afford the loss and ran the numbers, nothing can compete with a guaranteed return. Even a 3% return in todays market is over 1000x what prevailing cash earns.

Your post cuts to the core of all the decision making being discused And please beleive I am clueless. What happened 6 years ago was a historic downturn, it has happened before but on that scale it has been 80 years (1929). In your post you pass along your hard earned wisdom. ( you can also beleive we are all right there with you, almost no one escaped)
But to what extent does our experence in “the great recession” drive our future risk taking?
Some cut their risk as the stock market plunged and sold their positions (something is better than nothing) but now have missed the recovery. Many feel that although business and employment have improved the next downturn is just around the corner. The Mortgage Fraud, LIBOR Fraud, investor fraud and even defrauding the US goverment by the major banks and the defunding of the Justice Department financial crimes unit by congress and the Statement by Spencer Bachus, Chairman of the House Financial Services Committee that “Washington and regulators are there to serve the Banks” makes it clear that at this point the game is rigged and yet our economy depends upon risk taking. Who would be so foolish as to start a new business knowing that the banks can and will manipulate interest rates and real estate prices? I guess i think that for the short term most risk is unacceptable but I also think that if we dont do something to fix this mess there may be no road to a happy retirement. Gotta do more than vote folks!

If you can pay it off in a few years, go for it, and then you’ll have a LOT extra to save for the future.

Everyone’s situation is different. But paying off your house is a guaranteed return on interest. Sure, stocks have recovered for now, but that could change tomorrow, and the value of your retirement account could be slashed in half.

It happened to me for years…lose and lose and lose in my retirement accounts. Only now is it at a normal recovered amount.

But we are going to get rid of the mortgage and therefore have a “raise” of $900 every month and FREEDOM!

“Anon” – $900 a month invested now is worth more than $900 a month after you pay off your mortgage.

You miss out on the value of compound interest by waiting to invest for retirement.

BTW, if you do not feel confident in the stock market, there lots of other ways to invest for a secure retirement. Income-producing real estate would be just one example.

“FREEDOM” is only an illusion if you don’t have actual financial security. A paid-for house will always require payment of taxes, utilities and upkeep. A paid-for house won’t pay for groceries or medicine if you lose your job, for example. Unless, of course, you borrow against it, LOL.

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